The financial world is awash with ratios one form or another. Many are useful, some need to be taken in balance with other information and some are just contrived.
In my view the FI Ratio is one of those.
It is calculated by dividing your passive income by your expenses. Herein lies the first problem. What defines each of these. Basically, whatever you want – just ask an accountant !
So what does an FI ratio actually tell us ? Perhaps it is that if it is > 1.0 you have ‘made it’. Maybe you calculate as you go and use it to motivate more … I am 0.4 now.. now 0.65… now 0.81 etc …
It’s a contrived ratio after all.
- But would it work ?
- What Expenses ?
- What is discretionary and should fall outside these thoughts ?
What does ‘Passive’ and Expenses’ actually mean ?
There may be an actual definition of ‘Passive’, but to me it is like interest. It is monies received for no work but as a reward for investing. So Dividends, Interest, Bond coupons, REIT Income streams and anything similar. For me the ‘active’ bit is about growth (and that can be plus or minus).
As for ‘Expenses’, well, all mine cover Bills, Mortgage, Car, Home, Holidays, Fun etc etc but a fair chunk is essentially discretionary. In fact when I did my budget analysis it was essentially half. So all the fun parts of life covered around half of our plan.
So lets start where so many in FIRE start – the 4% ‘rule’
The 4% ‘rule’ is sometime stated as 25x needs, sometimes 25x expenses. It makes a real difference. I mean, just what do people actually think here ? For example, our actual must haves are £18K.. so 25x that is £450K. Using a 3.3% ‘rule’ more suited to the UK it is 30x at £540K (and this is basic living).
Mortgage is different as there is circa £66k left and it finishes in 6 years .. just a fund of £66K would do it.
So £600K ….. and this gets us basic living … mmmm … not very enticing.
But wait, wifey has an index linked small pension from BMW of around £6.8K.. so now I need 30X (£18k-£6.8k) = £336K (+plus mortgage lump).
So far so good … But lets suppose I want another £20K on top for holidays, fun, hobbies, restaurants etc .. wow .. another £600k+ needed.
I wonder if what is really meant is that passive income covers the necessary, then a rather more variable amount drawn covers life depending on returns.
So maybe what I need to consider is the question of What is my FI ratio using non discretionary expenses ?
OK .. that is a simple scribble.. what about a bit of thought using my actual numbers. For this year I did a budget analysis of what happened last year and what I could improve on to be more accurate, consistent and realistic this year.
Now for the purpose of this exercise (as I am looking at what I think ought to be funded by passive income if I go down this road), I have split this into 5 categories:
- Primary – Bills, Shopping, Car, Phone & Internet
- Discretionary – Going out, Health & Fitness, Cash & Misc
- Other – pretty well what’s left
This comes out as:
- Primary – £13,997
- Mortgage – £10,145
- Discretionary – £10,652
- Holiday – £9,000
- Other – £3,800
So a grand total of £47,562, or £37,997 if I exclude the Mortgage costs.
Clearly the bills have to be paid in full, but unless we plan on becoming hermits and eating spam fritters daily some measure of socialisation is a must (otherwise simply no point being retired). But 100% of plan… lets be realistic and say some would be cut back, so I am going to pick 75% of plan for my Discretionary and other spend. But Holidays are an extra so not including them.
- Primary – £13,997
- Mortgage – £0
- Discretionary – £7,989
- Holiday – £0
- Other – £2,850
So a grand total of £24,876 ….. ie approx £25K
My wifes BMW pension is £7K (rounded up), so essentially I would need a passive income of £18K for a fairly basic level, some meals out, a few hobby activities: a modest life.
This fits very well with how we have looked at things. Mortgage costs I will simply say lets have a fund set aside for that, so approx £66K right now if memory serves). Everything else comes out of growth and capital drawdown of the rest.
Logically then, I ought to perhaps invest in an annuity or indexed set of gilts and guarantee the £18K but the returns are less than inflation and just rubbish, so lets look at a low risk, low growth fund structure that has a yield of say 2.8% after costs (perfectly possible in the UK). Whatever fund structure is set-up it will be subject to market forces, so a balance of blue chips, broad ETF’s and Bonds with a world balance is likely to be the best option. When Stocks rise, Bonds fall. When Stocks fall, Bonds rise, and by using broad worldwide funds the vagaries of currency and relative market performance can be minimised, i.e. a ‘Balanced’ Portfolio (if not very dull).
OK so what Size of ‘Passive’ ‘Balance’ Fund do I need ?
Lets say that I want a fund that initially delivers 10% more than my passive target. So broadly would have to drop 10% for me not to get what I need in passive income. A bit of headroom seems eminently sensible. Excess can be either re-invested to gain a measure of compounding or saved into a separate cash fund for example.
At 2.8% I would need funds totalling £707K (including the extra 10%).
Really …. is this a valid strategy ?
What about the rest. Well, its only £37.5K in total (ignoring mortgage) less the £25K, so £12.6K.
But in 12 years time, our collective state pensions (post tax) will be more than this figure…. so really, I could say all I need is £12.6K for 12 years or about £150K. Add this to the £66K for a mortgage and suddenly I get a need of:
£707K + £150K + £66K => £923K
So at least on paper, I could set up a low risk, balanced return fund structure of circa £923K and that delivered a reasonable retirement (exceptional comes from additional growth)
There is an additional advantage in this…. I don’t take the passive income capital. Given I looked to have a slightly larger fund to start with, the odds are with very modest growth and reinvestment of the excess yield, in real terms it will be worth at least the same if not more. I looked a little while back at what we may need for end of life care costs in the UK for us both and came to conclusion that circa £750K would be needed.
So when we get to be dotty and need a care home we need approx £750K for the envisaged costs for us both.
Well blow me ! ….. That is what would be left, circa £750K+
Other useful factors about all its is that it would be largely fire & forget. Set up solid, diversified, balanced funds in low cost wrappers based on blue chip companies and funds (dull as dishwater types), and then enjoy retirement. Ain’t it funny that this is largely what an annuity does (but pays you at lot less – no wonder insurance companies have so much of our cash).
I started out thinking that much of the stuff about passive income and FI index etc was really just flannel for the masses and click-bate for bloggers who essentially do it all as a job ($40-$50K blog income is not a side hustle after all). In a lot of ways I still do. It is a contrived ratio, but the value is rather beyond this as it turns out.
It is an inherently lazy way of investing, but therein lies an unexpected attraction. When I look at how much time I spend background reading and researching, however enjoyable and interesting, I am not going to be doing it forever and there is the problem of what ‘er indoors will do if I suddenly pop my clogs !
Lazy it may be,
Lacking aspiration possibly,
Taking a dull uninteresting line definitely
…. But a solid level of passive investing does offer some unexpected attractions in its inherent simplicity.
Lots of ‘passive types’ bang the drum for all kinds of investing, Real Estate, Crowd Funding, this and that. Often these are not low risk arena’s and can be very illiquid. Really, quite a few should be classed as high risk. But the general principle of setting up a bunch of relatively uncorrelated diverse income streams that carry low risk and stable yield has rather surprised me by having some merit on reflection.
I had not thought about passive much before, but actually, this FI Ratio stuff has led me to have a think. Ultimately, everything we read about should be that…. make ‘US’ think. The answers are for each of us to call.
Something to further think on !
Now if this is a very ‘right-field’ dull as dishwater ‘steady-Eddie’ strategy, then an article I have in draft is very ‘left-field and high risk … I keep going back as it rather blows my mind a bit….must do an article sometime if the numbers work